Economics: Will the Euro Continue to Soar?
New York: January 03, 2005
By John R. Stephenson

If you have been following the currency markets, one thing is obvious - the U.S. dollar has been falling in value relative to most other currencies. The principal beneficiary? The Euro. The reason the Euro has been soaring is that the world badly needs a replacement currency for the U.S. dollar, the long serving world reserve currency. The reason? The dollar is a badly flawed currency that is getting weaker all the time as the U.S. government actively debases the currency in an attempt to deflate away the country's massive debts.

Currently, the United States is the world's largest debtor nation with most of this borrowing going towards non-productive uses such as a continued consumption binge resulting in more cars than drivers and more houses than households. The current account deficit (exports minus imports) is close to $600 billion dollars coupled with an enormous government budget deficit. The country is not competitive in spite of the massaged figures that are released by the U.S. government every month. Even though the official figures profess that the U.S. is more productive than the rest of the world and that productivity is steadily improving, the truth is that the U.S. is not competitive and is in fact buying more and more from the rest of the world each and every day. The Euro, it would seem, could function as the reserve currency for the world.

Certainly, there is much to be positive about with the Euro. The European Union has a population and economy that is larger that that of the U.S. In addition, the European Union has a balance of trade surplus compared to the massive debts and deficits of the United States. The world's central banks could easily sell off the nearly 60 percent of their foreign currency reserves that are currently held in U.S. dollars and simply buy Euros. If the Euro became the world's reserve currency, some estimates peg the resulting value of the world trade that would be conducted in Euros at 30 percent. As well, the success of the Euro as the reserve currency would make Europeans more competitive, resulting in lower costs for all of us. The idea of a single currency, which has been tried two or three times before in Europe, makes good sense as it reduces barriers to trade.

To make the Euro a reality, the European Union and twelve of its fifteen members (Britain, Sweden and Denmark opted out of the plan) voted to adopt the Treaty of Masstricht which, among other things, called for the creation of the Euro. The tough part of making the Euro work, was that the countries that made up the European Union each had very different economic and financial underpinnings. Some were creditor nations and other debtor nations, some had strong currencies and others had weak currencies. Of course, combining a crumbling currency with a strong currency is a recipe for disaster so the signatories to the treaty realized that they had to stipulate that each member country "converge" to a certain standard (budget deficits of 3 percent or less). That standard was that they each had to put their economic houses in order. That meant keeping their budget deficits within a certain band or pay enormous fines for violating the terms of the treaty.

The scheme worked and the Euro was created, in large part because the process was driven by the Germans who for fifty years had been the paragon of sound fiscal management. The Euro, as it was originally conceived, was really a Deutsche Mark in disguise. But as the 1990's progressed, the original sound money governments that signed the treaty were replaced with easy-money governments who were not inclined to stop spending and as the deadlines for convergence loomed, they began cooking the books. The French concocted a plan that called for them to take huge amounts of money out of the national pensions fund, use it to balance the books and then return the money after the deadline had passed. They were even audacious enough to announce the plan out loud. In the end, all of the countries cooked the books to show that they were in fact in compliance with the necessary standards of convergence.

Unfortunately, the concept is in crisis. With a common currency, the member governments have one less tool at their disposal when they get into trouble - the printing press. When the various member countries had their own currencies they could turn on the printing press and create money which would ultimately debase the money but would cause a short-term blip in the stock market and in consumption. Things would be good - for a while. The other option that individual nation states could adopt in the short-term is to borrow abroad. This is the circumstance in the United States today. With a common currency, the individual governments can no longer print money and the options when they get into financial difficulty are to borrow abroad or to run a sound economy that is competitive.

The likelihood is that they will be forced to borrow abroad. In fact, that is already happening with both the Portuguese and the Germans being amongst the biggest violators of the treaty. Not only will these countries incur large debts as the needs of say, Portugal diverge from those of Austria but their respective governments will start to blame outsiders for the mess they find themselves in. The likely focal point of their abuse? The bureaucrats in Brussels (the headquarters of the European Union). A chain is only as strong as its weakest link and with cheating rampant and with their aging populations and entrenched social welfare programs, it is highly unlikely that twelve individual European governments will all be able to run their economies properly. The result will be cheating en masse. What does this mean? The Euro will be unable to survive.

In the 1920s, the United Kingdom was the richest and most powerful country in the world and the British Pound was the reserve currency for the world. But the country was in deep economic decline and by the end of the 1930s, exchange controls were placed on sterling which lasted for forty years and resulted in the decline of the United Kingdom's empire, prestige and power. By the 1970s, the country could not create credit or currency at will and had to be bailed out by the International Monetary Fund. You can get away with it for a while but, in the end, the only way to maintain a strong currency is to keep your economic house in order.

The U.S. dollar is clearly in decline because of the country's poor productivity and huge government and personal spending. The Euro will likely continue to benefit in the short run (the next year or so) from the resulting decline in the U.S. dollar. Our prognosis for the Euro in the long run is not so rosy. The likelihood that twelve vastly different economies and cultures can all work in unison in a coordinate and fiscally responsible manner seems to stretch credibility. In my view, the Euro is unlikely to survive. Investors should look for the eventual sharp decline in the Euro as it makes its inevitable swan song over the next decade.

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